Charging for Capital

Last updated: 28 June 2010

Getting the price right refers not only to the amounts appropriated but also to the costs that go into the calculation of price. The capital charge is one such cost element; to my knowledge, New Zealand is the only country in which it applies to the central government. The charge is levied on the net worth (assets minus liabilities) of departments and some Crown entities. The assets are assessed on the basis that they are valued in financial statements and may include buildings and other fixed assets, cash appropriated for depreciation or held as working capital, inventory, or receivables. The capital charge represents the opportunity cost of money - what the government can expect to earn in alternative investments entailing similar risk. It may be thought of as an internal rate of return on the government's investment in its own entities. The standard charge was initially set at 13 percent, but is recalculated annually, and at the time of writing was about 11.5 percent.

The capital charge has a dual purpose: it signals that capital is not costless and should be managed as would any other cost of production, and it spurs managers to include the cost of capital in comparing the cost of outputs produced by government entities with the cost of obtaining the outputs from outside suppliers. The charge puts internal contracting on the same footing as contracting out and encourages full cost recovery of outputs sold to governmental or private users.

When it was introduced in 1991, the capital charge generated much confusion, undoubtedly because it was so novel and unfamiliar. Many tough issues had to be confronted in valuing assets and in computing the charge. Within a few years, however, the charge was widely accepted by chief executives and headquarters managers. There appears to be less appreciation of it in field and regional offices, where the charge tends to be viewed as a bookkeeping exercise rather than as an incentive to manage assets.

On introduction, departments were compensated for the charge; their appropriations were increased by an amount equal to the charge. (No compensation was provided for the charge apportioned to outputs sold to third parties.) Since then, changes in the capital charge due to changes in net worth (other than through revaluation of assets) has not been automatically compensated. If a department disposes some assets, and returns capital to the Crown, the charge will be reduced accordingly. Inasmuch as the charge is part of the pool of operating funds that can be used at the discretion of the chief executive, the money saved by having the capital charge reduced can be used for other operating purposes. This rule gives departments a strong incentive to divest surplus assets, to maintain working capital and inventories at efficient levels, and to consider renting rather than buying office accommodations and other facilities. Surveys conducted by the Treasury and outside consultants confirm that the capital charge has spurred departments to actively manage their assets and to incorporate the cost of the charge in setting user charges.

I have some concern, based on the incentive structure rather than on empirical evidence, that the capital charge may lead over time to the under-capitalisation of some departments. When the charge was introduced, the presumption was that inasmuch as capital had previously been a free good, some departments were overcapitalized. Treasury should monitor departmental behaviour to guard against the pendulum swinging in the opposite direction. My concern is based on two perverse incentives: one for departments to avoid the capital charge on the value of their cash accumulation due to depreciation by returning cash balances to the Crown; the other is that departments may see little advantage in making cost-saving investments that add to the capital charge.

In assessing the impact of the capital charge, it should be noted that the assets of most departments are in the form of cash or the value of IT equipment, not in buildings or facilities. At the end of May 1996, cash balances of all departments totalled $800 million, more than half of which were held by the New Zealand Defence Force and the Ministry of Education. These two departments may require substantial cash balances because of the value of their physical assets; other departments that have few fixed assets maintain small cash balances.

In view of the continuing rapid fall in the cost of IT, Treasury can have reasonable assurance that the capital charge does not discourage departments from investing in new technology. Even with the capital charge, departments have incentives and resources to upgrade their systems.